Companies that build online marketplaces struggle to solve the dreaded chicken and egg problem — how do you get buyers without sellers and sellers without buyers onto the platform? Many of today’s familiar online marketplaces — like Uber, AirBnB, eBay, Xbox Live, PayPal, OpenTable, and Angie’s List — managed to crack this challenge and reach sustainable scales. In addition to creating useful products for their users, most analysts would agree that these businesses also benefit greatly from positive network effects between their buyers and sellers. That is to say, each additional buyer or seller on the platform generally has a positive effect on his or her counterparty:

More sellers -> more options for quality, price, and convenience for buyers

More buyers -> more opportunities to transact for sellers

Many people are ready to give these companies the benefit of having solved for positive network effects on their platform. In fact, I too fell into this trap until Professor Gautam Ahuja of Ross School of Business (visiting at HBS last year) made me re-examine this belief. Rather, there exists an opportunity to more deeply understand these companies by exploring the network effects across all party interactions. We can gain a better idea of the costs involved in growing the business and what valuable follow-on products should be developed.

The basis for this company analysis begins by understanding that multi-sided platforms must inevitably also have multiple network effects. To clarify what this means, it might be easier to first understand what network effects look like on a single-sided platform.

A Single-Sided Network Example: Early Facebook

When Facebook first came on the scene in the mid-2000s, it resembled a single-sided platform. In the time before marketers were peppering the site with ads — weren’t those the days! — users basically joined other users in a system where all users were alike. We can think about Facebook’s network effects by looking at what happened when a single new user joined (an increment of +1 new users).

The incremental user’s content provided other users with more to see and explore. This content came in the form of posts, photos, and music preferences and meshed seamlessly into other existing users’ experiences. An existing user now has more to explore and interact with on the site — like seeing pictures of the new user’s trip to Bali or discovering linked articles the new user shared. Existing users’ content might also get more interactions from the new user in the forms of more likes, comments, and tagged photos. These could all be described as positive effects as they generally enhanced the value for Facebook users.

However, the addition of a new user could make the Facebook experience turn negative as well. The new user might constantly post pictures of their cat and make it difficult for existing users to find the content they really wanted to see in their newsfeed. The new user could also be someone existing users didn’t want on the site, like a coworker or boss, which would make them less inclined to share photos or other content. Quite simply, the network effects induced by one new Facebook user could be positive or negative.

The insight into Facebook’s network effects helps us understand a lot about what followed in the company’s history. Because the effects were predominantly positive, people invited their friends and family to the site virally, reducing expensive marketing and growth costs. The site exploded and reached 1.49 billion monthly active users as of June 2015 and saw 1 billion different users log in on the same day in August 2015. Facebook subsequently developed products like a filterable newsfeed (no more cat pictures from the new user) and privacy tools to reduce users’ pain points (only share photos with friends or make posts visible to friends “except XYZ” people) that resulted from its rapid growth and negative network effects. These developments could have been predicted by our simple analysis of identifying the network and its positive and negative attributes.

A Multi-Sided Network Example: AirBnB

When thinking about multi-sided networks, the model for analyzing network effects grows more complex. Rather than thinking about how an incremental user will affect the entire network, we should scrutinize who the incremental user is and what network is being affected.

To illustrate this more clearly, let’s consider a two-sided platform like AirBnB. When a new user joins the AirBnB site, we should first consider whether the user is a guest or host. Next, we need to explore how that additional guest or host affects other guests and hosts. For this two-sided network example, there exist 4 possible network effect scenarios:

How does an incremental guest affect hosts?

How does an incremental guest affect other guests?

How does an incremental host affect guests?

How does an incremental host affect other hosts?

Understanding network effects can quickly get complicated when dealing with multi-sided platform. The number of unique network effects necessary to consider is n² for each distinct n type of parties on the platform. As we saw with Facebook, network effects can be either positive or negative, complicating our understanding of two-sided platforms even more. When considering positive or negative effects, the interactions that should be examined are 2n².

Below I’ve illustrated how AirBnB might experience positive and negative network effects across all 4 of its network change scenarios:

An Updated Model for Thinking About Network Effects: Uber

The AirBnB analysis is a useful starting point, but I find it easier to simplify each of the distinct networks into a more manageable characterization. This reduction allows us to quickly understand the dynamics in the networks of a company while maintaining an explainable simplicity. I therefore classify interactions into one of three buckets.

Collaborators (Positive) — Parties predominantly enhance the experience of other parties in the network. Examples of collaborators include funders on Kickstarter who together to support an idea or product or gamers on xBox live who play together in multiplayer Halo battles. Such relationships encourage users to invite other users to a site, and can lead to organic site growth and lower user acquisition costs.

Counterparties (Positive) — Parties are involved predominantly in a monetary transaction or exchange that satisfies both sides. Examples buyers and sellers transacting for a deal on Groupon or a mother ordering food via delivery service Sprig. Parties exchange clearly identifiable goods and services, which, when priced at a point such that the transaction clears, creates value for both parties that supports repeat usage and high user lifetime value from multiple transactions.

Competitors (Negative) — Parties predominantly compete for resources or opportunities. Examples include applicants applying to Y Combinator where only a select number of applicants are accepted or eBay bidders competing against each other for a baseball autographed by Mickey Mantle. In both cases, competition is likely to give users a worse user experience as they might not secure the opportunity or good or end up paying a higher price. This can result in a lowered user experience, unsubscribing, and high sign-up or reactivation expenses.

By using this framework, it helps me understand the operational costs a company is likely facing and what products they might consider developing in the future. For example, if this analysis were applied to ride-sharing start-up Uber, it might look like this:

For Uber’s two-sided platform, a large part of the company’s value comes from solving the most obvious network dynamic: matching drivers with riders and riders with drivers. The company was able gain a foothold in markets like San Francisco because cab companies were not keeping pace to satisfy this counterparty need. As more drivers joined Uber, riders benefitted with greater ride availability and more riding options (uberPOOL, uberX, uberXL, uberTAXI, UberBLACK, uberSUV, uberSELECT, uberPOP, uberBIKE, etc.). As more riders sign up, drivers are more likely to match with a pick-up request and earn money for their services. These services led to increased usage by both riders and drivers as value was realized.

However, this dynamic doesn’t necessarily lend itself to growth. Drivers aren’t actively inviting or converting new riders, and new riders aren’t energetically recruiting new drivers. The first time they usually encounter each other is during an Uber ride, at which point they’re both already on Uber’s platform. While a positive experience for each party — a clean, convenient ride for the passenger and a profitable transaction for the driver — will influence who how often the other party uses Uber in the future, they’re not actively growing the platform.

The story gets more interesting when you look at the network dynamic across the rider <-> rider and driver <-> driver dimensions. For current riders, each additional rider chiefly means increased competition for resources. In Uber’s case, this manifests itself in surge pricing when many people try and use the app at the same time — such as during a rainstorm or Friday rush hour. The experience is painful, and users are upset by either the wait time to find a rider or the total cost for the trip. Similarly, as more drivers join the platform, existing drivers face both increased competition for riders and reduced chances for earning surge prices. If driver’s aren’t able to find riders and drive around unoccupied, this cuts into the driver’s ability to earn for time worked.

By understanding the interplays occurring across its networks, it’s easier to identify and appreciate Uber’s growth, marketing, and development challenges over the past few years. While Uber has benefitted from word-of-mouth marketing for its remarkable service, much of Uber’s recent growth depends on promotions and discounts rather than virality. Because riders and drivers aren’t actively working to sign up other drivers and riders without an incentive, Uber bears the burden of these growth costs itself.

For example, Uber offers money to users (riders and drivers) who sign up new riders and use a unique promotion code (mine is below — feel free to join using it!). Additionally, Uber will give new riders one or more free rides upon joining. To sign up new drivers, Uber offers drivers a $500 bonus after completing their 20th ride, $500 dollars for signing up a Lyft driver, and fixed hourly income guarantees to ensure new drivers realize monetary gain immediately — with promotions often varying city by city. These acquisition costs can be large for a company looking to scale globally and help explain why Uber has raised massive amounts of cash to grow operations in areas like China, India, and other parts of Asia. In addition to building and operations costs, a lot of that money will likely go to signing up riders and drivers through aggressive promotions and discounts and launching citywide marketing campaigns. Given Uber rider’s lifetime value from its positive counterparty interactions, such costs can likely be easily justified.

On the product development side of the business, Uber’s network effects can explain a lot of what the company has focused on building. Paramount to the experience is maintaining a positive rider <-> driver and driver <-> rider dynamic. Anything that facilitates a quality service has taken precedent in the pipeline to protect the company’s advantages and keep users using the app. Such developments include credit card scanning for easier payment, license plate information to help riders identify drivers, written explanations for 3 star or below reviews to protect drivers’ reputations, and optimal route maps to make sure the most cost-effective route is taken.

Uber has worked to tackle negative network effects inherent to its business as well. Uber launched a fare split feature that aims to make the riding experience more collaborative and less competitive, easily allowing users pay each other and receive ride receipts. Additionally, a feature was added to surge that allows users to be notified once surge has dropped below as certain level, decreasing the pain from increased competition over resources. Finally, uberPOOL matches different rider pairs so that a each group receives a lower fare for carpooling with the other party. These features all subtly aim to shift the experience from competitive to collaborative.

Looking Ahead

In this post, I hope that I’ve helped lay out a new model to help understand network effects for multi-sided online marketplaces. By identifying all the distinct networks that exist and then understanding the interplay of people in those networks (collaborators, counterparties, competitors), one can develop a valuable tool for understanding much about an online business. This insight can be used to analyze a company’s growth and marketing costs — will users sign other users up or do they need to deploy resources? It can also give vision into a business’s product development priorities — what networks need to be protected with better products and which networks need pain points addressed.